Weekly Broker Wrap: Oz M&A, Banks, Aviation, Chemicals And IT

This story features MOUNT GIBSON IRON LIMITED, and other companies. For more info SHARE ANALYSIS: MGX

-M&A targets
-Bank exposures to bankruptcies
-Dividend differences for major banks
-Is Oz aviation now more rational?
-Chemical sector under pressure
-IT positioning for a rebound
 

By Eva Brocklehurst

A spate of merger and acquisition transactions in the Australian market has made short positions a dangerous pursuit and reversed the underperformance of some stocks. BA-Merrill Lynch makes this observation and screens potential ASX 200 targets by applying the metrics of recent transactions. Metrics include cheap valuation, low financial leverage and good free cash flow.

So which stocks could be next in the firing line? The broker cites miners where the market is sceptical of analysts' forecasts, such as Mount Gibson Iron ((MGX)), Fortescue Metals ((FMG)), Sandfire Resources ((SFR)), Regis Resources ((RRL)) and Evolution Mining ((EVN)). Mining services providers are also prominent on the list and include WorleyParsons ((WOR)), Downer EDI ((DOW)), Monadelphous ((MND)) and Mineral Resources ((MIN)). Consumer stocks Myer ((MYR)), Wotif.com ((WTF)) and Seven West Media ((SWM)) are inexpensive, have low leverage and good free cash generation as do iiNet ((IIN)) and Telecom NZ ((TEL)) among the telcos. The uptick in M&A activity is encouraging for Macquarie Group ((MQG)), given its exposure to capital markets and Merrills notes Macquarie's Australian deal flow was the highest in more than five years during April.

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Australian banks which are most exposed to the mass retrenchments by single employers, in the context of consumer asset quality and a default environment, are the subject of a sector review by Credit Suisse. The broker observes ANZ Bank ((ANZ)) is more exposed to recent high profile closures announced by Holden, Ford, Toyota and Boeing, based on branch density by postcode. This also reflects ANZ's concentration in manufacturing and its domestic home market of Victoria.

More generally in regard to regional personal bankruptcy trends, the broker considers Commonwealth Bank ((CBA)), followed by National Australia ((NAB)) as relatively exposed to higher volume bankruptcies. CBA has a high percentage of its national branch network in four of the ten most stressed regions. Suncorp ((SUN)) has a relatively high percentage of its national branch network in three of these regions – all in Queensland. Bank of Queensland ((BOQ)) has a high percentage in three, with two in Queensland and one in Perth. CBA and Westpac ((WBC)) have exposure to three of the least stressed regions via their branch networks and Bendigo and Adelaide Bank ((BEN)) has a relatively high percentage of its national branch network in four of the lowest regions for potential bankruptcy.

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Macquarie has looked at the underlying differences in the major banks in terms of their dividend outlook. Share price performance has been driven by dividend growth, while APRA's recent adjustments to capital requirements have stymied the rising pay-out story. Macquarie suspects some banks may start building capital again. At face value CBA seems most affected by the new rules, with $2.2bn in Colonial gearing costing 65 basis points in capital to bring the normalised CET1 ratio to 7.85%, while ANZ is the least affected at 22 basis points.

APRA has approved a transition period for the new rules and the banks could use "slow burn" tactics such as discounted dividend reinvestment plans (DRP), constrained risk weighted asset growth and slower dividend growth as remedies. The broker thinks such tactics would be a recipe for the market capitalising a temporary capital build as a low dividend growth outlook, as was the case in 2010-2012. Alternatively, the major banks could close the gap by partially underwriting their DRPs. Macquarie believes CBA is best placed in this scenario and includes two 50c special dividends for CBA in FY15 and FY16 estimates. NAB and ANZ will need to raise more capital through DRPs to get to the required levels. This means an earnings downgrade by the broker for those banks of 1-2% over FY15 and FY16.

(See also: Australian Banks: Result Season Scorecard on the subject of banks and their capital positions.)

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Is Australia's aviation industry becoming more rational? Deutsche Bank was encouraged by Qantas ((QAN)) announcing it will keep capacity flat during the first quarter of FY15. Yields appear to be increasing as well, but the broker remains cautious about the near-term profitability of airlines. Qantas' capacity as measured by available seat kilometres (ASKs) is relatively flat but the actual seats in the booking system are continuing to grow at over 2%, based on both Qantas and Jetstar brands. This implies that planes are being redirected to shorter routes but the question remains regarding what actual upward pressure this will have on yields, given the capacity growth was previously directed, the broker suspects, to the resources sector, which is currently slowing. Virgin Australia's ((VAH)) booking system suggests available seat growth will average 1.5% per month and Deutsche Bank expects Virgin to take more market share from Qantas.

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Australia's chemical sector earnings continue to deteriorate as both pricing and volumes weaken. Morgan Stanley believes Orica ((ORI)) is the most exposed to this weakness. The broker believes the downturn in explosives earnings, evident in the fist half of 2014, is only just beginning. Feedback from investors revealed they think Australian miners are not interested in using foreign ammonium nitrate, given perceived risks to mining operations. Morgan Stanley's survey suggests such faith in the Australian duopoly of Orica and Incitec Pivot ((IPL)) might be misplaced, as the majority of miner respondents are interested in lower cost imports under the right circumstances. Australian explosives prices fell 1-5% on average in 2013 and a further 3-5% decline is expected this year.

Morgan Stanley has found little evidence to explain away the weak volume growth as a function of miners high grading their mines. The broker thinks structural factors are more likely, such as more efficient blasting techniques and a shift to emulsion use. Volume shocks from Australian coal mine closures are also increasingly likely.

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IT services are positioning for a rebound but Morgan Stanley thinks there is a risk that demand may not stabilise until well into FY15. The broker finds there is limited scope for price rises or a rapid acceleration in IT projects to drive earnings higher. Still, utilisation rates are depressed and any top line growth should absorb existing capacity, providing operating leverage. Growth, annuity earnings and a discount to peers amounts to a compelling investment case for CSG ((CSV)), in the broker's view. Morgan Stanley expects the company to more than double its earnings in FY14 compared with FY12. Comparing listed players in terms of the annuity mix, offshore capability and client sector exposure casts a favourable light on Oakton ((OKN)). Market expectations of the stock are modest and Morgan Stanley observes a strong balance sheet and scope for operating leverage. Oakton has moved its mix most aggressively offshore and endured the most price deflation.
 

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